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Driving Your Financial Investment? Perhaps a License is Needed

Vox Populi

Increasingly, individuals in the United State are in charge of their financial well-being after retirement. This is fundamentally a good idea. It is a basic principle of liberal philosophy that people should be in charge of their own lives, and that includes saving for retirement and investing their retirement wealth. It's also a good idea because the financial distress of pay-as-you-go public pension schemes will make it more and more difficult for governments to support their citizens' retirements. However, too little attention is paid to the fact that successfully investing for retirement requires financial knowledge and competence, and financial mistakes may not only harm the people who make them, but society as a whole. For example, a completely clueless investor may ruin himself and his family financially, ending up elderly and poor. He will also impose a cost on society, since some form of financial support will eventually be provided by taxpayers. Society has an interest in helping individuals make good investment decisions.

Annamaria Lusardi
Annamaria Lusardi (Photo by Joseph Mehling '69)

The risk is real since financial ignorance is rampant. Evidence from a major U.S. survey—the Health and Retirement Study (HRS)—shows that about half of older Americans do not understand the concept of compound interest and the difference between nominal and real interest rates. An even larger percentage does not know that investing in a single stock is riskier than investing in a diversified mutual fund. These mistakes are often compounded by peer effects: many people follow their friends' advice in financial matters. A recent study in a leading financial journal shows that church attendance, a social activity, leads to a larger propensity to own stocks. Fellow churchgoers like to dispense financial advice and people listen to them. A clueless investor can also be easily fooled by unscrupulous financial advisors.

When left to their own retirement saving and investment decisions, people may simply postpone the decision until it is too late. A striking finding from the HRS is that lack of planning and lack of knowledge about pension rules is widespread among American workers. It may be that young people do not plan for retirement since they face an uncertain future and money may be tight. But the fact that one-third of older workers have not thought at all about retirement is not a good sign, since not planning is tantamount to not saving. Lack of preparedness is also apparent from how little current workers know about Social Security and pensions. Not only are most workers incorrect about the age at which they will be eligible for Social Security benefits, but about half of the older workers surveyed in the HRS do not even know which type of pensions they have.

How do economies implement a system where workers are in charge? People will only buy into it if they can benefit from it. A system that limits risk would be something from which everyone could benefit. Perhaps we could learn something about steering our financial futures from driving schools, where the goal is to prepare drivers to obtain their licenses. Why do we require drivers to have a license? First, we want to be sure they know the rules of the road and have basic driving skills. Second, knowledge and skills related to safe driving will decrease the chance that they will do harm to themselves and others. Like a clueless investor, a reckless driver hurts himself, his family, and society as a whole.

A financial driver's license issued by each state would not cost much and does not need to be another large public program. In fact, it could be administered via a Web page and be based on standardized tests. One does not need to be a financial wizard to manage his or her savings, just like a driver does not need to be a mechanic or a Formula One racer to be out on the road. And, with the same amount of time required to prepare for a driving test, investors could learn some basic information that could prevent horrible mistakes. Moreover, rather than listening to random tips, workers would acquire knowledge about fundamental financial concepts, like diversifying, exploiting the power of interest compounding, and taking advantage of employers' pension matches and tax-favored assets.

People should repeat the test if they fail and should show their financial licenses to their employers. Employers, in turn, could be required to direct employees without licenses to a default pension plan or to consultations with a certified financial planner. Acquiring competence and financial literacy will also empower workers and help them appreciate the potential advantages of an "ownership" society. Ask yourself: If you weren't required to obtain a driver's license, would you take the time to read a driving manual before hitting the road? Maybe. But which one would you read? These are questions that face investors all the time.

The financial license may be a low-cost way of increasing savings for retirement and avoiding personal financial disaster. Will financial drivers' licenses solve all the problems? No. Driver's licenses can't prevent all accidents. We have already agreed that the benefits of driving with a license outweigh the risks of the road. In the same way, we are increasingly coming to understand that the benefits of being able to invest freely as individuals, with minimum training, outweigh the risk of financial "accidents." The point is that we are willing to limit risk on the roads because we recognize the danger to individuals and to society. We should take the same measures to reduce the risk on household balance sheets.

By ALBERTO ALESINA, professor of economics at Harvard University, and ANNAMARIA LUSARDI, professor of economics at Dartmouth

Questions or comments about this article? We welcome your feedback.

Last Updated: 12/17/08